Summary
In Newark Milk Cream Co. v. Commissioner (C.C.A.) 34 F.2d 854, deduction was refused for money paid by a corporation to a former stockholder to make up a fixed return guaranteed to former stockholders who dismissed litigation against the corporation in exchange for such payment.
Summary of this case from Brawner v. BurnetOpinion
No. 4007.
September 11, 1929.
Appeal from Board of Tax Appeals.
Petition by the Newark Milk Cream Company to review an order of the United States Board of Tax Appeals upholding a ruling of the Commissioner of Internal Revenue. Order of Board of Tax Appeals affirmed.
The following findings of fact and opinion were filed February 13, 1928, by the United States Board of Tax Appeals:
"This is a proceeding for the redetermination of deficiencies in income tax for the years 1922 and 1923 in the respective amounts of $3,788.75 and $3,241.15. The only issue to be decided is whether certain payments made by the petitioner under an agreement are deductible from gross income for each of the years involved. The other issues raised by the pleadings were settled by a stipulation of the parties reading as follows:
"`The parties hereto, by their respective attorneys, stipulated and agree as follows:
"`(1) That the net income of $350,432.54 for 1922, as shown in the copy of the 60-day letter attached to the petition in the above case, includes Liberty Bond interest in the amount of $13,716.89, which should be excluded from such net income in the computation of the tax liability for said year.
"`(2) That the petitioner is not entitled to a loss on the sale of old obsolete equipment in the amount of $544.03, or any other amount, as claimed in the petition.
"`(3) That this stipulation disposes of assignments of error Nos. 4(a), 4(b), and 4(c), and leaves for disposition before the Board assignment of error No. 4(d) only.'
"Findings of Fact."The petitioner is a New Jersey corporation. It has for many years been engaged in the business of distributing milk and dairy products in Newark, N.J., and surrounding territory. In the year 1921 it was operating 50 or 60 different milk routes. At that time, and for several years prior thereto, the petitioner's stock was owned as follows:
The Bennett estate ............... 125 shares George O. Scheerer ............... 122 " William Scheerer ................. 1 share Paul Scheerer .................... 1 " Stanley A. Rutz .................. 1 "
"William H. Bennett had died in 1915. After his death differences of opinion arose among the stockholders as to the policies of conducting the petitioner's business.
"The operations of the petitioner in each town were subject to the supervision of the board of health of such town. Each board of health made regular inspections of the petitioner's operations within its jurisdiction. One of the regulations common to all of said boards of health was that grade A and grade B milk should be bottled in separate plants. During the year 1921 the petitioner was operating a grade A and grade B bottling plant in the same building in violation of the foregoing regulations. Its buildings and equipment were inadequate at that time to operate both a grade A and a grade B bottling plant. The building which it was using as a bottling plant was originally used as a tobacco factory and was approximately 40 years old. It was a brick building, with wooden floors and beams. The petitioner had waterproofed the floors, in order to make it suitable for use as a milk plant. The machinery used was a heavy type, and the petitioner was at times put to considerable expense in making repairs.
"In the year 1918 the petitioner was ordered by the Newark board of health to comply with the regulation with reference to bottling grade A and grade B milk, and was given a certain limited time in which to provide suitable buildings and equipment. The board of health threatened to rescind the petitioner's license to operate, if the regulations were not complied with. The petitioner attempted to make the improvements demanded, but was unable to do so, on account of the opposition of the heirs of the Bennett estate; they objecting specifically to any plan of refinancing which was necessary in order for the petitioner to acquire the needed facilities.
"In March, 1919, the Bennett estate brought suit against the petitioner, its officers, directors, and stockholders, in which it sought to have a receiver appointed for the petitioner, and to have the acquisition of new buildings and equipment by the petitioner enjoined. The litigation was given publicity in the local papers, and resulted in serious detriment to the petitioner's business.
"During the year 1921, and for several years prior thereto, the petitioner was confronted with strong competition; the competitors at times selling milk below the cost of production.
"On December 29, 1921, the parties involved in the aforementioned litigation entered into the following agreement: "`Agreement made and entered into this twenty-ninth day of December, 1921, between Newark Milk Cream Company, a corporation of the state of New Jersey party of the first part, George O. Scheerer and William Scheerer, parties of the second part, and Ida Melisse Bennett, Robert Elwood Bennett, and Chester Bennett, parties of the third part, witnesseth:
"`Whereas, the party of the first part is a corporation of the state of New Jersey engaged in carrying on the milk and cream business in the city of Newark and vicinity; and
"`Whereas, the parties of the second part are owners of a substantial amount of the capital stock of the party of the first part; and
"`Whereas, the parties of the third part are interested as beneficiaries in one hundred and twenty-five (125) shares of stock of the Newark Milk Cream Company and certain shares of the stock of the Alderney Dairy Company now held by the Fidelity Union Trust Company, a corporation, as executor of and trustee under the will of William H. Bennett, deceased; and
"`Whereas, litigation has now been pending for many years involving among others the party of the first part and also the parties of the second and third part; and
"`Whereas, this litigation has been greatly detrimental to the business and the interests of the party of the first part, has taken the attention of its officers from its business, distracted its employees and been generally demoralizing to the best interests of the party of the first part, and its stockholders; and
"`Whereas, in this litigation, the parties of the third part have incurred large expenses and disbursements for counsel fees, attorneys' services, accountants' charges, investigators, and otherwise; and
"`Whereas, the party of the first part is now confronted by the necessity of raising large sums of money to be used in making necessary repairs in, alterations to, and additions to its present plant and equipment, and the party of the first part can not do its necessary financing while such litigations are pending; and
"`Whereas, all of the parties hereto realize that the present litigation is disastrous not only to the corporation, the party of the first part, but also to the parties of the second and third part, and for that reason they have agreed upon a settlement of all of their differences:
"`Now, therefore, in consideration of the premises, the mutual agreements hereinafter made and one ($1.00) dollar by each of the parties hereto to the other paid, the receipt whereof is hereby acknowledged, it is mutually agreed by and between the parties hereto as follows:
"`1. The party of the first part agrees with the party of the third part to pay unto William Harris, Esquire, counsel of the parties of the third part, the sum of forty-five thousand ($45,000.00) dollars, said sum to be in full payment of his fees as counsel of the parties of the third part in the litigation above referred to, and to also cover all disbursements made or incurred for expenses of every kind whatsoever in connection with said litigation, said sum to be paid coincidently with the date of the execution of this agreement.
"`1a. This agreement shall be binding upon and for the benefit of the parties hereto and their respective heirs, executors, administrators and successors wherever the context requires or admits.
"`2. The parties of the third part consent that the Fidelity Union Trust Company of the City of Newark as executor and trustee under the last will and testament of William H. Bennett, deceased, shall sell and transfer said 125 shares of the stock of the Newark Milk Cream Company and also the shares of the stock of the Alderney Dairy Company held by it, together with all the right, title and interest of the parties of the third part or of the Fidelity Union Trust Company as executor and trustee as aforesaid, in and to the Newark Milk Cream Company to the parties of the second part for the sum of $200,000.00 in cash. The parties of the third part agree to execute such consents or other authorization as may be required by the Fidelity Union Trust Company in connection with the sale of said stock as aforesaid by the Fidelity Union Trust Company. The parties of the second part agree to purchase said shares of stock from the Fidelity Union Trust Company upon the terms set forth in this agreement. The parties of the second part further agree as further consideration for the transfer of said stock to pay and discharge when due, all federal income taxes and all other taxes and charges which may become due and payable on account of the sale and transfer of said shares of stock from the Fidelity Union Trust Company to the party of the second part.
"`3. The party of the first part guarantees unto the parties of the third part, that the Fidelity Union Trust Company as executor and trustee under the will of William H. Bennett, deceased, shall so invest said sum of $200,000.00 as to produce a gross income of $1,333.33 a month for a period of ten years after the date of this agreement, and that the Fidelity Trust Company will distribute the income payable to the parties of the third part in equal monthly installments on or before the last day of each and every month; first payment to be made on or before the last day of January, 1922, and the party of the first part agrees that in the event said sum shall not be so invested and the gross income upon its investment in any month during the next ten years shall amount to less than $1,333.33 that then and in such event, the party of the first part will pay to the said Fidelity Union Trust Company as executor and trustee under the last will and testament of William H. Bennett, deceased, at the end of every month, the difference between the amount of said gross income and the sum of $1,333.33 a month. If for any reason the party of the first part either fails or is unable to perform the undertaking set forth in this paragraph, then the said William Scheerer, one of the parties of the second part hereby personally guarantees unto the party of the third part that the Fidelity Union Trust Company as executor and trustee under the will of William H. Bennett, deceased, shall so invest said sum of $200,000 as to produce a gross income of $1,333.33 a month for a period of ten years after the date of this agreement, and that the Fidelity Trust Company will distribute the income payable to the parties of the third part in equal monthly installments on or before the last day of each and every month; first payment to be made on or before the last day of January, 1922, and the party of the first part agrees that in the event said sum shall not be so invested and the gross income upon its investment in any month during the next ten years shall amount to less than $1,333.33, that then and in such event, the party of the first part will pay to the said Fidelity Union Trust Company as executor and trustee under the last will and testament of William H. Bennett, deceased, at the end of every month, the difference between the amount of said gross income and the sum of $1,333.33 a month. It is understood that there is no guarantee as to the amount of income or as to the method of payment thereof after then (six) years from the date hereof.
"`4. The parties of the second part will endeavor to procure the agreement of the Fidelity Union Trust Company not to charge against the estate of William H. Bennett, deceased, any legal expenses, fees or disbursements in connection with the participation of the Fidelity Union Trust Company in any of the above mentioned litigations, and they further will endeavor to procure the agreement of the Fidelity Union Trust Company not to ask for commissions upon so much of the corpus of the estate of William H. Bennett, deceased, as consists of said sum of $200,000.00, being the purchase price of said shares of stock, in excess of the rate of 1½ per cent. Should the parties of the second part fail to secure such agreement upon the part of the Fidelity Union Trust Company, or should the Fidelity Union Trust Company be allowed or receive such legal expenses, fees or disbursements or commissions in excess of the percentage above set forth then the parties of the second part agree to pay any sums allowed to the Fidelity Union Trust Company for such legal expenses, bills or disbursements or allowed to the Fidelity Union Trust Company for commissions in excess of the percentage above referred to upon any accounting made by it.
"`5. The parties of the third part agree upon the consummation of the stock transfer above mentioned to consent to the discontinuance of all proceeding against the Fidelity Union Trust Company as executor of and trustee under the last will and testament of William H. Bennett, deceased, and the parties of the third part further consent to the continuation of said Fidelity Union Trust Company as such executor and trustee. The parties of the third part agree that this agreement is an adjustment of all claims existing upon the part of the parties of the third part as against the said Fidelity Union Trust Company and arising out of the administration of the estate of William H. Bennett, deceased, by said Fidelity Union Trust Company with reference to said share of stock. The parties agree that the said shares of stock shall be transferred to the party of the first part and the said sum of $200,000.00 referred to in the second paragraph of this agreement, shall be paid on the 5th day of January, 1922, at the office of McCarter English, No. 765 Broad street, Newark, New Jersey, at the hour of 3 o'clock in the afternoon.
"`6. Upon the payment of the sums mentioned in the foregoing paragraph, the parties of the third part agree to consent to the discontinuance of all litigations now pending in any of the courts of the state of New Jersey, and involving the party of the first part, the parties of the second part or the Fidelity Union Trust Company, as executor and trustee under the last will and testament of William H. Bennett, deceased, and the parties of the third part further agree to consent to the vacation of any restraint now imposed upon the party of the first part, its officers, directors of (sic) stockholders under any order or decree of the Court of Chancery of New Jersey. The parties also agree at said time to execute and deliver, each to the other, general releases releasing each other and all officers and directors of the Newark Milk Cream Company and Alderney Dairy Company from all liabilities or responsibilities of any character whatsoever, except those of compliance with and performance of any obligation and duty arising out of the terms of this agreement.
"`7. All legal proceedings are to be discontinued without costs to any of the parties as against the other.
"`8. The parties agree to execute any further agreements or papers of any character necessary to fully and completely carry out the terms of this agreement.'
"The above agreement was entered into at the suggestion of the court before which the litigation was pending, and was thereafter approved by the court. The only litigation pending at the time the agreement was made, however, was a petition for an injunction to prohibit the officers of the corporation from purchasing property, buying new equipment, or making additions to the plant. The application for receivership for the petitioner had been denied in the early part of the year 1919.
"At the time the Bennett heirs offered to sell out their half of the stock under the terms that were later incorporated in the agreement, they also offered to purchase the other half of the stock for $200,000.
"The amount of $200,000 received by the Bennett estate under the terms of the said agreement was invested at 6 per cent. per annum. Thereafter, for each of the years under appeal, the petitioner became obligated to pay, and did pay under the said agreement, $4,000 per year to the said Bennett estate.
"George O. Scheerer and William S. Scheerer were in good financial condition at the time the said agreement was executed and could have paid out of their individual funds a substantial part of the $200,000 given in payment of the stock.
"Soon after the transfer of the stock under the terms of the said agreement, the petitioner constructed a new modern building and complied with the other requirements of the Boards of Health.
"Opinion."The only question for determination is whether the amounts paid by the petitioner during 1922 and 1923 upon its guaranty to the Bennett estate are deductible from gross income. The petitioner contends that the amounts were paid as ordinary and necessary expenses of carrying on the business and are therefore deductible.
"In the year 1921 the heirs of the Bennett estate, who owned 50 per cent. of the petitioner's stock, were out of accord with the business policies of the company and successfully opposed the carrying out of plans for improvements that were essential to the prosperity of the business, if not to its existence. They had petitioned the court for an injunction to restrain the officers of the company from making certain improvements which it appears the company was required to make in compliance with existing regulatory laws. At the court's suggestion, it was agreed by way of settlement that the Bennett heirs should sell out their stock to the other stockholders and drop the litigation against the petitioner. The petitioner, as a party to the agreement, promised to pay the attorney's fees of the Bennett heirs arising out of the litigation and guaranteed the Bennett estate a return of 8 per cent. upon the $200,000 to be paid for the stock for a period of 10 years. It was upon this guaranty that the amounts in dispute were paid out by the petitioner.
"It is contended on the part of the petitioner that the guaranty was made specifically as a consideration for the discontinuance of the litigation and was therefore a necessary expense. We are unable to find in the agreement, which is fully set forth above, any specification that the guaranty was made solely as a consideration for the termination of the litigation. Neither can we infer as much from the agreement as a whole, in fact the contrary appears to be true. The terms and conditions of the guaranty are set forth in paragraph 3 of the agreement. Paragraph 6 states that:
"`Upon the payment of the sums mentioned in the foregoing paragraph, the parties of the third part agree to consent to the discontinuance of all litigations now pending in any of the courts of the state of New Jersey, and involving the party of the first part, the parties of the second part or the Fidelity Union Trust Company, as executor and trustee under the last will and testament of William H. Bennett, deceased, and the parties of the third part further agree to consent to the vacation of any restraint now imposed upon the party of the first part, its officers, directors of (sic) stockholders under any order or decree of the Court of Chancery of New Jersey. The parties also agree at said time to execute and deliver, each to the other, general releases releasing each other and all officers and directors of the Newark Milk Cream Company and Alderney Dairy Company from all liabilities or responsibilities of any character whatsoever, except those of compliance with and performance of any obligation and duty arising out of the terms of this agreement.'
"Paragraph 5 states in part:
"`The parties agree that the said shares of stock shall be transferred to the party of the first part and the said sum of $200,000.00 referred to in the second paragraph of this agreement, shall be paid on the 5th day of January, 1922, at the office of McCarter English, No. 765 Broad street, Newark, New Jersey, at the hour of 3 o'clock in the afternoon.'
"The litigation pending at the time was a petition by the Bennett heirs for an injunction to restrain the officers of the corporation. Upon the sale of their stock the Bennett heirs had no basis for the continuance of the litigation. The amount paid to them was in consideration of the sale of their stock. Clearly there was no additional consideration necessary for the termination of the litigation, nor does the agreement show that any was given.
"Looking at the agreement as a whole, we must conclude that the guaranty was as much a consideration for the transfer of the stock as was the promise to pay the $200,000. The fact that the liability upon the one was assumed by the individual stockholders, and upon the other by the corporation, does not distinguish them. It should be noted that the stock was closely held. Prior to the transfer of the Bennett estate stock, George O. Scheerer and his brother, William Scheerer, parties of the second part to the agreement, held 123 of the 250 shares outstanding, and thereafter an additional 125 shares. It is to be further noted that by a promise set forth in paragraph 3 of the agreement William Scheerer gave his personal guaranty upon the obligation assumed by the corporation.
"It was held in Laemmle v. Eisner (D.C.) 275 F. 504, that amounts paid as attorney's fees in litigation for control of certain stock resulting in practically the ownership or control thereof were capital expenditures and were not deductible as ordinary and necessary expenses of carrying on a business. In Earl M. Palmer, 3 B.T.A. 403, we held that an amount paid in settlement of a dispute and litigation was a capital expenditure and not deductible from gross income. See, also, Consolidated Mutual Oil Co., 2. B.T.A. 1067; Vivian Harcourt, 2 B.T.A. 940; Harry E. Lutz, 2 B.T.A. 484; John C. Moore Corporation, 3 B.T.A. 430.
"The distinction is clear between cases where amounts are paid out as a result of litigation, or as a means of settling a dispute arising from ordinary business transactions, and cases such as the instant one where the payments were made in order to gain control of a business. Under the circumstances we are of the opinion that the amounts in controversy are not deductible from gross income.
"Judgment will be entered on 15 days' notice, under rule 50."
Lee I. Park, Charles D. Hamel, and Richard S. Doyle, all of Washington, D.C. (Hopkins, Starr, Hopkins Hamel, of Washington, D.C., of counsel), for petitioner.
Mabel Walker Willebrandt, Asst. Atty. Gen., and Sewall Key and Andrew D. Sharpe, Sp. Asst. Attys. Gen. (C.M. Charest, Gen. Counsel, Bureau of Internal Revenue, of Washington, D.C., of counsel), for respondent.
Before BUFFINGTON, WOOLLEY, and DAVIS, Circuit Judges.
This is an appeal by the Newark Milk Cream Company, the taxpayer, from an order of the Tax Board. The proceeding was for the redetermination of deficiencies in income tax for the years 1922 and 1923 in the respective amounts of $3,788.75 and $3,241.55. The facts are stated in detail and discussed at length in the opinion and findings of the board, and by reference thereto we avoid needless repetition. The case turns on what is the proper construction of an agreement entered into by the taxpayer company and contending sets of stockholders of the taxpayer in settlement of litigation, of business differences, policy, and the sale by one set and acquisition by the other of stock with an accompanying financial guarantee of the taxpayer to the selling stockholders. No principal of law is involved. The case concerns this individual contract, and the only issue decided by the Tax Board and now before this court is whether certain payments made by the Newark Milk Cream Company, in pursuance of its guaranty in the contract, were deductible from its income as being ordinary and necessary business expenses of the taxpayer corporation. The board held the payments were not ordinary and necessary business expenses, but were parts of the price paid by the present stockholders to buy out their fellow stockholders and get control of the company.
After a careful study of record, we find ourselves in accord with the conclusion of the board, and therefore affirm its order.